Currency appreciation and trade surplus

This column argues that if a real appreciation in the Chinese currency is not achieved through exchange rate adjustment, it will happen through inflation in China and deflation in the US. It says a better Chinese policy mix would involve nominal appreciation of the renminbi combined with absorption-increasing policies such as developing human infrastructure.

Before the crisis, the US ran large trade deficits with East Asia, oil-producing countries, and the rest of the world. This is not the case for China. Table 1 shows exports, imports, and the trade balance between the US and the rest of the world before and after the collapse of Lehman Brothers in September Exports and imports both exhibited sharp drops beginning in October The sample is thus divided into the year before the crisis October - September , the first year after the Lehman shock October September , and forecasts for the second year after the Lehman shock October — September The year before the Lehman Brothers shock is from October to September The first year after the Lehman Brothers shock is from October to September The second year after the Lehman Brothers shock is from October to September The forecast for the second year is derived by multiplying data for the first ten months i.

These results are presented in Figure 1. Predicted exports or imports represent the sum of predicted exports or predicted imports from 31 countries based on a gravity model. The gravity model includes income in the exporting and importing countries, the real exchange rate, distance, a common language dummy, importer and exporter fixed effects, dummy variables for Mexico and Canada, and a time trend as explanatory variables.

Many argue that continued foreign reserve accumulation by the Bank of China is unsustainable because it produces an increasingly inefficient allocation of resources. Both private and social rates of return are much higher for investments in the Chinese economy than for investments in US securities. For instance, investing in education would pay high dividends by helping Chinese firms to assimilate new technologies and move up the value chain.

Investing in rural education is particularly important see Rozelle Most rural children in China cannot afford pre-school, and even though elementary school is free attendance has declined because of poor accessibility and long, dangerous commutes. At the high school level, tuition is expensive 20 times the per capita annual income of the rural poor and little financial aid is available. As a result, only one in four rural students finish high school.

It can do this by using some of its foreign exchange reserves to buy local currency. The resulting demand stops the currency's depreciation but also acts to reduce the domestic money supply in two ways. First the bank is directly removing some of the nation's currency from circulation as it buys it up. Secondly, if the central bank overshoots the target, the intervention can create or worsen a current account deficit due to the propped-up exchange rate being more favorable for importers than for exporters.

This deficit sends currency out of the country, further decreasing liquidity. The resulting lowering of the money supply likely will have a deflationary effect which can be undesirable, especially if the country already has substantial unemployment. To offset the effect on the money supply, the central bank may sterilize its foreign exchange intervention. It can do this by engaging in open market operations that supply liquidity into the system, by buying financial assets such as local-currency-denominated bonds, using local currency as payment.

A sterilized intervention against depreciation can only be effective in the medium term if the underlying cause behind the currency's loss of value can be addressed. If the cause was a speculative attack based on political uncertainty this can potentially be resolved. In practice, the cause driving sterilized interventions in the late 20th century was often that a high money supply had meant local interest rates were lower than they were internationally, creating the conditions for a carry trade.

This involves market participants borrowing domestically and lending internationally at a higher rate of interest, a side effect of which is to exert downwards pressure on the currency being borrowed. Because a sterilizing intervention holds the money supply unchanged at its high level, the locally available interest rates can still be low. The carry trade therefore continues to be profitable and the central bank must intervene again if it still wants to prevent depreciation.

This can only go on so long before the central bank runs out of foreign currency reserves with which to intervene. A central bank can intervene on the foreign exchange markets to prevent currency appreciation by selling its own currency for foreign currency-denominated assets, thereby building up its foreign reserves as a happy side effect.

If the cause was a speculative attack based on political uncertainty this can potentially be resolved. In practice, the cause driving sterilized interventions in the late 20th century was often that a high money supply had meant local interest rates were lower than they were internationally, creating the conditions for a carry trade.

This involves market participants borrowing domestically and lending internationally at a higher rate of interest, a side effect of which is to exert downwards pressure on the currency being borrowed.

Because a sterilizing intervention holds the money supply unchanged at its high level, the locally available interest rates can still be low. The carry trade therefore continues to be profitable and the central bank must intervene again if it still wants to prevent depreciation.

This can only go on so long before the central bank runs out of foreign currency reserves with which to intervene. A central bank can intervene on the foreign exchange markets to prevent currency appreciation by selling its own currency for foreign currency-denominated assets, thereby building up its foreign reserves as a happy side effect.

However, because the central bank is creating or at least releasing more of its currency into circulation, this will expand the money supply — money spent buying foreign assets initially goes to other countries, but then soon finds its way back into the domestic economy as payment for exports.

The expansion of the money supply can cause inflation, which can erode a nation's export competitiveness just as much as currency appreciation would. The classic way to sterilize the inflationary effect of the extra money flowing into the domestic base is for the central bank to use open market operations where it sells bonds domestically, thereby soaking up new cash that would otherwise circulate around the home economy.

A variety of other measures are sometimes used. Other countries also found sterilization more costly after , relating to expansionary monetary policies adopted by advanced economies hit by the financial crisis , most especially the United States. In contrast to interventions against currency depreciation, there is no inherent limit on interventions aimed at preventing appreciation.

If a central bank runs out of domestic currency to buy foreign reserves, it can always print more. There can be political pressure from other nations if they feel a country is giving its exporters too much of an advantage, at the extreme this can escalate to currency war.

There can also be political pressure domestically if commentators feel too big a loss is being made by the sterilisation operations.